Saturday, June 6, 2009

Lending 'Reform' We Don't Need

Reading proposed legislation designed to "reform" the mortgage market is usually a depressing experience for me. Most of the proposals would take us further from a competitive system that works for borrowers. This is certainly true of HR 1728, called the Mortgage Reform and Anti-Predatory Lending Act, which passed the House and was winding its way through Senate when this was written.

Virtually every section of the House bill, an amendment to the Truth in Lending Act, bears the fingerprints of consumer groups or mortgage lenders. Legislators and their staffs operate under the illusion that by refereeing between these groups, they can achieve a balance between the interests of borrowers and those of lenders. This is an illusion because most of the policies espoused by consumer groups further the interests of consumer groups, not those of consumers. Consumer groups look to entangle lenders in a maze of complex rules and potential liabilities, which provide opportunities to counsel and litigate for borrowers, and make special deals with selected lenders.

Unfortunately, neither lenders nor consumer groups want to make the market work more effectively because a well-functioning competitive market would both force down prices and reduce the need for consumer groups.

The mortgage market works poorly because borrowers know so little relative to the loan originators they deal with. Economists call this the problem of information asymmetry. There are two major tools for overcoming information asymmetry: mandatory disclosures, which are discussed below, and transaction simplification rules, which I will discuss next week.

Under mandatory disclosures, government requires that lenders disclose what borrowers need to know to negotiate on an equal basis. We have had mandatory disclosure for three decades, however, and it has not helped borrowers in the slightest. Mandatory disclosure has raised lender costs and lengthened transaction periods, but for the most part has left borrowers as confused and overwhelmed as before. Indeed, judging from the many hundreds of letters I have answered on the subject, the required disclosures in many cases have created more, rather than less, confusion.

The reasons are well known to everybody familiar with the process, including many consumer groups: The total volume of disclosures is excessive, overwhelming borrowers; a large proportion of disclosed items is garbage of no value to borrowers; some disclosed items are irreconcilable with others because they originate with different agencies; and none are abreast of the current market.

The major source of these problems is the early decision by Congress to make itself the source of many of the items subject to disclosure. The garbage disclosures all come from Congress. As just one example of many, the requirement that every transaction must show the sum of all scheduled monthly payments over the term of the loan, which is a completely useless number, is in the law.

Congress is also responsible for entrusting the two most important disclosures -- truth in lending and the good-faith estimate of settlement -- to two agencies (the Department of Housing and Urban Development and the Federal Reserve) that have never succeeded in reconciling them. And of course, there is no possible way to keep disclosures up to date when substantive changes require new legislation.

The remedy is obvious: Congress should remove itself from disclosure operations and eliminate all existing congressionally mandated disclosures. Sole responsibility for all mortgage disclosures should be entrusted to one agency, which would have the legal authority to set and revise the rules as needed. This is the approach taken a few years ago, to good effect, in Britain.

The approach taken by HR 1728, in contrast, leaves the current disclosure system in place and adds a new set of mandatory disclosures to the pile. Under one of them, lenders will be obliged to disclose "the comparative costs and benefits of each residential mortgage loan product offered, discussed or referred to by the originator." Compliance with this rule alone, ignoring extensive other new disclosures stipulated in HR 1728, would probably double the size of the garbage pile dropped in the lap of hapless borrowers. Needless to say, none of the existing garbage disclosures would be eliminated.

The cardinal sin of any disclosure system is overload because borrowers have limited time and attention span. Disclosing too much is the same as disclosing nothing because nothing is absorbed. Adding even a badly needed and well-designed new disclosure to an existing pile of garbage disclosures does nothing but increase costs. An agency whose sole business is disclosure would quickly learn this, but Congress never will.

There's still room to improve foreclosure rules

A competitive mortgage market that would work for borrowers requires an effective system of disclosures and transaction simplification rules to equalize the playing field between borrowers and loan originators.

As indicated BOVE, an effective disclosure system would require the end of all existing congressionally mandated disclosures, which are largely useless, and entrust sole responsibility to one agency that would set and revise the required disclosures as needed.

Transaction simplification rules are needed to separate third-party service transactions from the mortgage transaction, to sharply reduce the number of lender charges that can vary from loan to loan and to assure the validity of price quotes. These rules would empower borrowers to protect themselves from abuse by loan providers.

-- Rule 1, as simple as it is obvious, is that any third-party service required by lenders must be paid for by lenders. The cost of these services would be embedded in the mortgage price, in the same way that the cost of automobile tires is embedded in the price of an automobile. But the price would be much lower because lenders can buy the services for less than borrowers, and it would no longer needlessly complicate the mortgage transaction.

-- Rule 2 would limit lender charges to points, expressed as a percent of the loan amount, which are traded off against the interest rate, and one fixed-dollar fee that must be posted and the same for all transactions. This rule would eliminate fee escalation, which is common practice.

-- Rule 3 would require that the prices that lenders lock be the same as the prices they quote to a borrower shopping the identical loan on the same day. This rule would eliminate low-ball price quotes, which pervade the market.

Not surprisingly, none of these rules is found in the current bill, which is aimed not at empowering borrowers to protect themselves but at replacing private decision-making by lenders with government-imposed rules.

Some of the rules in the bill are sensible, such as the requirement that mortgage originators be licensed. It would also prohibit the sale of single-premium credit insurance, which would be barred by my more comprehensive Rule 1. But other rules -- essentially knee-jerk reactions to abuses that arose during the go-go years before the crisis -- are toxic.

One involves mandating detailed underwriting rules and procedures, which is in effect Congress telling lenders how they must assess risk. This is the same kind of legislative overreach that Congress embedded in Truth in Lending, where it specified the items that had to be disclosed, with the disastrous results discussed last week.

A second toxic rule requires that lenders be responsible for assuring that borrowers who refinance obtain a "tangible net benefit." In every refinance, the net benefit depends on something known only to the borrower. Making the lender liable for what is in the borrower's head is bad policy.

A third rule would require that all mortgage lenders retain 5 percent of the credit risk on any loan they sell. I am not sure whether this rule will prove toxic or not, but it will raise costs, especially those of the smaller lenders who sell all the loans they write.

The current bill provides an escape hatch from these three rules, in effect waiving them on "qualified mortgages." A qualified mortgage has an annual percentage rate no more than 1.5 percent above that of a "prime" transaction, on which the borrower's total payment obligation does not exceed some maximum to be prescribed by regulation, has a 30-year term and fully documents the borrower's financial status.

The qualified mortgage escape hatch from these rules will divide the market between qualified and nonqualified mortgages. The nonqualified group will be larger, because it will include all loans with terms other than 30 years; loans with debt-to-income ratios above the level deemed prime by the regulators; loans to borrowers with FICO scores below about 660, who pay a rate premium of about 1.5 percent in the current market; most loans to self-employed borrowers; most loans for investment purposes or on properties other than single-family houses; and all loans with risk variables that in combination require a risk premium of more than 1.5 percent.

In the current market where risk premiums are extremely high, that covers a lot of ground.

The bill in Congress says nothing about the down payment, the most important risk variable of all. If prime loans are viewed as having down payments of 20 percent or more, which is consistent with the concept of "prime," mortgage insurance on loans with smaller down payments will increase their APRs, pushing many of them into the nonqualified sector as well.

Borrowers taking nonqualified loans will pay a price increment charged by lenders to cover the additional liabilities they assume under the bill. This will be an addition to the large risk premiums they already pay in a highly risk-averse market. Prime borrowers get a pass.